Attorney Seeks Revisions to Proposed Branch Currency Transaction Regs

Dear Sir/Madam:

The notice of proposed rulemaking (REG-208270-86) dated September 6, 2006, replaced prior proposed regulations (the "1991 Proposed Regulations") with new rules (the "2006 Proposed Regulations") that differ substantially both in their implementation of the profit and loss method mandated by the statute and in their treatment of transfers between a qualified business unit and its owner. The 2006 Proposed Regulations include some significant improvements in terms of administrability. For example, the proposed rule that the amount of a remittance should be determined as a net annual transfer (in contrast to the daily netting required by the 1991 Proposed Regulations) effects the statutory purpose of section 987 in a manner that substantially reduces the compliance burden. There are, however, a number of other areas in which the 2006 Proposed Regulations could be revised to significantly reduce the compliance burden without departing from their spirit and approach. This letter sets forth suggestions for such revisions.

Translation of Profit and Loss Statement

The statutory provisions of section 987 are remarkably simple. In brief, all the statute provides is that the taxable income of a taxpayer that has a qualified business unit ("QBU") with a different functional currency should be determined:

Leaving aside the question of whether the statutory terms are best read as allowing for different exchange rates for different components of income or loss of the QBU, the translation of the P&L under the 2001 Proposed Regulations is notably more burdensome than under the 1991 Proposed Regulations. The increased burden is most extreme in the case of costs of inventory property. As illustrated in Prop. Treas. Reg. 1.987-3(f), Example 1, the deduction for cost of goods sold is determined by translating the cost of each unit of inventory sold (determined on a LIFO or FIFO basis, depending on the taxpayer's method of accounting) at the historic exchange rate for such unit of inventory. This rule seems unnecessarily burdensome. Taxpayers in general have a strong incentive to maximize the number of inventory "turns" in a year. Given that gross receipts from the sale of such inventory will be translated at the yearly average exchange rate (rather than at the item-by-item spot rates) and given that inventory can be expected to be sold soon after it is acquired,³ it would seem to do no violence to the principles of the 2006 Proposed Regulations, and would substantially lighten the compliance burden, to allow the yearly average exchange rate to be used also in determining the cost of sales deduction in the case of inventory property.

Spot Rate Convention

Prop. Treas. Reg. 1.987-1(c)(1)(ii) permits a taxpayer to elect to use a spot rate convention that "reasonably approximates" the daily spot rate. The proposed regulations do not provide a safe harbor for what constitutes a reasonable approximation, although examples show that a rate determined on a monthly basis would qualify. In Treas. Reg. 1.988-1(d)(3), a safe harbor for a spot rate convention in the case of payables and receivables arising in the ordinary course of business is a rate that is determined at intervals of one quarter or less. It would seem reasonable and would reduce the burden of compliance if the proposed regulations would specify that a rate that is determined on a reasonable basis at an interval of one quarter or less would satisfy the requirements for the spot rate convention. Such a quarterly determination would be particularly helpful in the case of cost recovery for fixed assets (which, under the rules for translation of P&L items, is done at the spot rate for the time of acquisition of the asset).

Transition Rules

The proposed transition rules (in section 1.987-10) generally allow for two methods of transition to the new regulations (once they become effective) -- the "deferral transition method", which uses a final computation determined under the taxpayer's previous method of applying section 987, and the "fresh start transition method", which requires determining and continuing to use the historic exchange rate for every asset and every liability existing on the date of adoption of the method in the proposed regulation. The mechanism of the fresh start transition method is constructed so that a taxpayer will, in determining the unrecognized section 987 gain or loss for the first year of application of the new regulations, determine the cumulative section 987 gain or loss of all assets and liabilities of the QBU.

Prop. Treas. Reg. section 1.987-10(a)(2) provides that, a taxpayer who used an unreasonable section 987 method in the past (such as, for example, failing to make the required determinations for any open taxable year)⁴ has available only the fresh start transition method. Prop. Treas. Reg. section 1.987-10(c)(2) provides that the taxpayer, together will all members that file a consolidated tax return with the taxpayer, and any controlled foreign corporation of which the taxpayer owns more than 50% of the voting power, must apply the same transition method for each qualified business unit that is subject to section 987.

It appears from these provisions that, if the taxpayer has failed for one year to make required determinations for any controlled entity in any open taxable year, then such taxpayer (and all of its controlled foreign corporations) will be required to use the fresh start transition method. This has the potential for substantial double counting of section 987 gain or loss. For example, if the taxpayer and each of its controlled affiliates have complied with section 987 (and have, accordingly, recognized section 987 gain or loss upon remittances) for most, but not all, open years, then the use of the fresh start method will likely lead to duplicated section 987 gain or loss, since that (required) method treats all cumulative section 987 gain or loss as unrecognized, while the taxpayer may have recognized some of the section 987 gain or loss in years for which the taxpayer did employ a reasonable method of complying with section 987.

The proposed regulations do prohibit double counting, but do not specify how this prohibition is to be implemented. One suggested addition to the regulation would be to permit taxpayers who have at some time in the past reasonably conformed to section 987 (but who have not done so for all years or for all controlled entities) to file amended returns for entities in their controlled group that were not in conformity with the prior section 987 method for certain open years. Any taxpayer availing itself of this opportunity should then be eligible to use the deferral transition method. Alternatively, the prohibition on double counting should be made more explicit by providing, for example, that a taxpayer who had recognized section 987 gain or loss with respect to a QBU at some time in the past, but who was using the fresh start method, should adjust the unrecognized section 987 gain or loss for the first year by the amount of any section 987 gain or loss that had previously been recognized.

Inbound Liquidations and Asset Reorganizations

The preamble to the proposed regulations requests comments on the treatment of an inbound liquidation as a termination, noting that Treasury is concerned about the importation of built-in losses (or similarly beneficial tax attributes) that were generated while the owner of the section 987 QBU was not subject to U.S. taxes. This concern, which is understandable and valid, can be addressed directly without having the liquidation or reorganization trigger a termination. For example, the regulations could provide that, immediately prior to any inbound liquidation or asset reorganization, a taxpayer should recognize the net unrecognized section 987 loss (if any) of each section 987 QBU, and that the basis in the section 987 marked assets of such "loss" QBUs should be adjusted accordingly. That would prevent the importation of losses (or similarly beneficial tax attributes) while allowing for continuing deferral of built-in gains (which, as the preamble notes, are more likely to be subject to U.S. tax after the transaction than before).

I would be happy to discuss any of these comments and suggestions at your convenience.

² A different rate is used if the asset is a Section 987 Marked Asset.

³ This is especially true in the case of taxpayers who use the LIFO method of inventory accounting.

⁴ It is not clear whether a failure to make the required determinations in a closed taxable year would be treated as the use of an unreasonable method. This point, also, should be clarified.